Markets rarely leave you in doubt that you’ve got something very wrong and the yen has been an outstanding example of that over the past couple of years. The Japanese currency has slumped against almost every other country, even as the stock market has been hitting new highs and the economy has been looking more promising than it has for a very long time.
Against the US dollar, the yen has gone back to where it was in the 1980s when a prolonged period of across-the-board dollar strength and tensions over the growing US trade deficit led to the Plaza Accord agreement. This has taken almost everybody by surprise. No analysts forecast such extreme weakness and most have been expecting the yen to stabilise and rise at every point along the way.
One common explanation is the gulf between interest rates in Japan, where the base rate is effectively zero and the 10-year government bond yields just over 1%, and most of the rest of the world, where rates have risen rapidly since 2022.
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Yet while this may play a part, it seems unlikely to be the whole story. The yen today is far weaker than it was before the global financial crisis (the last time interest-rate differentials were roughly this wide), both in nominal terms and after adjusting for differences in inflation.
The reason behind a weak yen
A notably weak currency is generally seen as negative. It pushes up import costs and weakens the global purchasing power of households and businesses. Rapid declines are also seen as potentially destabilising for businesses and the financial system.
The Bank of Japan has clearly been intervening in the market from time to time to sell currency reserves and buy yen – you can tell this from sudden surges in the exchange rate that keep foreign exchange traders on their toes but have had little impact on the longer-term trend. Still, while the weak yen creates problems, there is another angle to consider.
Was it good that it was so strong in the first place? The strength of the yen took place against very prolonged weakness in the economy, helping to entrench deflation and making exporters less internationally competitive. It is striking that evidence of a turnaround has emerged as the currency weakens. Japanese firms are growing exports and investing more overseas.
Deflation has turned to inflation and wages are rising. Without trying to untangle correlation and causation, it seems possible that a healthy turnaround in the Japanese market needed to be accompanied by a reversal in the oppressively strong yen.
Regrettably, that hypothesis didn’t occur to me before this huge decline; neither had I heard it suggested by any long-term Japan bulls. It’s also true that continued weakness could create more harm than benefits. Realistically, we would expect the yen to strengthen eventually, especially if the Bank of Japan starts raising rates.
However, I would not expect it to go back to where it was three years ago – although this episode has once again shown why forecasting currencies is even more perilous than most predictions.
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